Some investors rely on fundamental analysis, such as earnings, revenues, liabilities, assets, and growths, to buy and sell bonds or stocks. To these, the performance of investments should be measured by estimating if the economics of underlying assets are compelling or not, instead of following metrics that predict the future of investments by analysing their price patterns in the past, like Technical Indicators.
The kind of concept they follow for instance, is that for a company’s stock price to rise of fall, there must be a shift in its sales and profit trends. Another example is that the demand and supply trends of oil should determine how it trades.
What are the important indicators that fundamental investors look at before investing?
There are a number of pointers that fundamental investors normally look at before going for a stock or bond. First, they must know if the data they’re looking for is for a bond or a stock as these two investments have their differences.
Investing in bonds normally involves a direct process of both evaluation and engagement. Bonds have a declared date of maturity and semi-annual interest payment (coupons?) that enables an investor to earn a steady stream of income as payment for purchasing the bond. What a fundamental investor typically does in this case is to ensure that the body (government or corporation) that is issuing the bond is strong enough to see out the maturity date.
Stocks on the other hand, are different because there is no stipulated date of maturity. Although every stock’s value rely upon the performance of the underlying business overtime, some stocks don’t pay steady amounts of dividends as most stocks do. The onus is on the investor to determine through business trends, if the stock will follow or exceed expectations.
Determining the value
Investors watch out for purchase values that represent great buys; some prices portend high success rates of investments.
For bonds, the primary indicator that an investment is right is the coupon or interest rate. Market forces affect the rates of interest on bonds: a bond that once had a 6% rate could shoot to 8% or reduce below 6% in the future. Although the investor gets to be paid back his or her original investment, he or she would have lost out on the future increment or gained if the rates plummetted; it all depends on the situation
For stocks, valuing a company using the price-earnings ratio (P/E ratio) is the ideal way for fundamental investors to go about things. The P/E ratio shows the share value of the company. It basically tells how much an investor is willing to pay per dollar of earnings. Other valuations an investor may consider include estimating the earning power of the business and how it can maintain its edge over the years. The P/E ratio is a much more simpler method than other stock technical analysis methods as the price-earnings ratio normally reflects the incomes, profits and problems of companies.
For other investment types, placing a finger on value can be more challenging. The fundamental approach however, is generally the same.
Tracking the cash flow
Another conviction of fundamental investors is that the future cash flow of an investment is another indicator of the investment’s performance. Analysis are employed to assess the cash flow in the future to arrive at the present value using a discount rate.
The discounted cash flow (DCF) is the kind of analysis that investors use to estimate the future cash flow of an investment to determine how valuable it (the investment) may be.
The approach of using fundamental analysis to determine investment value cuts across every kind of investing. Having the basic knowledge of how P/E ratio and DCF works, is a great foundation for taking on the investment world even if you don’t possess the knowledge of an expert.